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Drug Fails! What's Next for Investors?

After getting knocked down, investors ask, "What now?"

When a biotech's lead drug fails, investors are left with the difficult choice of whether to sell, often at a large loss, or hold on for better things. Sometimes, when the market overreacts to the failure, it might even act as a buying opportunity to add shares.

In the case of perifosine's failure, we have two companies -- Aeterna Zentaris(Nasdaq: AEZS) and Keryx Biopharmaceuticals(Nasdaq: KERX) -- to investigate, since they were partners on the drug. Unfortunately, valuing both is a little difficult at the moment.

Dead yet?On Monday, the companies said the phase 3 trial testing perifosine didn't meet the primary endpoint of improving overall survival in colon cancer patients. But we don't really know whether perifosine's development is dead since no data was presented. The companies based the phase 3 trial on data from very few phase 2 patients, and Keryx said the placebo patients survived longer than expected, so it's entirely possible that there was a trend favoring perifosine, but it didn't reach statistical significance.

Of course, the companies probably would have said something in the press release or conference call about a trend in the right direction if there was one, so it seems safe to assume Perifosine is done as a treatment for colon cancer.

Perifosine is also in a phase 3 trial for multiple myeloma. There are plenty of examples of cancer drugs that have failed in one tumor type but succeeded in others. Pfizer's (NYSE: PFE) Sutent, Bayer and Onyx Pharmaceuticals' Nexavar, and Roche's Zelboraf -- all approved drugs -- failed in other indications.

But perifosine's multiple myeloma trial has been slow to enroll, and the lack of efficacy in colon cancer won't make that any easier. No decision has been made, but if you read between the lines, the company's comments sure make it sound like the perifosine program will get shut down.

Assuming perifosene is dead, where does that leave the two companies?

Generic competitionKeryx has another drug, Zerenex, in phase 3 development, with data expected in October. Assuming it's positive, Keryx could file in the first quarter of next year and have a drug on the market by the end of 2013. The company had $31 million in the bank at the end of March, which would be enough to get it through an FDA filing, but Keryx would probably need to find a partner or a raise capital before a launch.

The opportunity for Zerenex is nowhere near the market potential for perifosine. Keryx says the U.S. market for the anemia treatments is about $750 million, but Zerenex will face indirect generic competition when Sanofi's (NYSE: SNY) market-leading Renagel goes generic in 2014. Figure Zerenex captures around 15% of the market, or about $100 million. Assuming a valuation of 5 times sales, there's upside from here, but remember, that valuation is years away with a couple of binary events -- phase 3 results and FDA decision -- and a likely dilution between now and peak sales.

Dilution comingAeterna Zentaris' diagnostic AEZS-130 already passed its phase 3 trial. But it's a test used to diagnose adult growth hormone deficiency, which occurs in only 6,000 adults annually. AEZS-130 has potential as a treatment for cancer patients who are losing weight and muscle mass, but it's only recently entered phase 2 development. The company also has another cancer drug, AEXS-108, which will enter a phase 3 trial in endometrial cancer before the end of the year.

With a market cap of less than $100 million, Aeterna Zentaris looks cheap considering its pipeline, but investors are factoring in dilution between now and profitability. The company says the $46 million it had at the end of the year is enough to stay afloat for the next 12 months, but there's no way the company is profitable by then.

Buy, sell, or Watchlist?I don't see much reason to own either company at this point. With no upcoming catalysts, both are dead money for the immediate future. Longer term, Aeterna Zentaris looks like the more interesting play, considering the more substantial pipeline. But waiting for the inevitable dilution might be the best move; just look at Discovery Laboratories(Nasdaq: DSCO), where it was clear the company needed to raise funds, but the biotech took a 20% haircut in doing so.

Holding biotechs over binary events is risky, but holding while burning cash waiting for long-off catalysts isn't a way to make money, either. Instead, consider profitable companies that already have products on the market where the stock price will be tied to sales growth. Companies like this one.